Audit Fee Competition Threatens Financial Reporting

Tim Reason, editorial director of CFO.com and award winning business journalist, has a new article out in this month’s CFO Magazine, “Auditing Your Auditor.” It is always a pleasure to read his work, and his current piece is no exception.

His focus is on audit fees. As everyone knows there are three certainties in life: death, taxes, and CFOs complaining about pricey audit fees. About 2,500 public companies (out of 9,500 SEC reporting companies) pay at least $1,000,000 per year in audit fees.

Audit prices have been on a roller coaster in recent years. When the Big 8 industry evolved into the Big 4, a smaller pool of major audit providers led naturally to higher prices. Eventually, though, audits become commoditized (and coupled with consulting fees) and prices fell. Following the turmoil of the early 2000s and passage of Sarbanes-Oxley, audit prices went through the roof. Recently, however, prices have been dropping. Reason cites information gleaned from AuditAnalytics reports that supports a conclusion that audit fees have been dropping as a percentage of a client company’s revenues even as corporate revenues have declined during the recent recession.

Reason reasons that declining audit fees result from three factors:

Benefits realized from SOX required internal controls,

Increasing trend for companies to shop for a new auditor on price considerations only, and

CFO’s comparing their audit fee against a benchmark of average fees paid by their peers.

I wonder, though, if this is the complete story.

The audit industry is still an oligopoly. In an oligopoly, a few large suppliers are able to ration their scarce supply to the highest bidders. The Big 4 share of the SEC market is actually increasing! Moreover, from all accounts SOX is a hollow, ineffective government mandate. Neither companies nor auditors are taking it seriously (there are exceptions, of course).

I think there are three reasons for this newly established trend to lower audit prices:

It’s the economy! Unemployment doubled in the U.S., to 10% from 5%. If history serves as a guide, it can take two years to recover each 1% of that unemployment. I don’t think the economic recovery will take all of ten years, but it will take a long time. Companies are arguing legitimately and successfully that they simply don’t have the money to support the Big 4 in the manner to which they’ve become accustomed.

Audit firms are willing to accept lower fees. The Big 4 collectively dominate every capital market in the world. It is a primeval world of cutthroat competition to win and keep clients. Although audit firms are not starved, they are hungry. A lost client (to another firm) is so damaging that firms correctly reason that a reduced fee is better than no fee.

It is already established that the weaker partner in the corporation-auditor relationship has sold its soul by degrees, a little here or a little there. Now the two parties are haggling over the price. If we go back far enough in history, we can see where audit firms scrapped their mission of acting in the public interest and went into the business of selling clean audit opinions. This is when the audit became commoditized. Certainly the industry was in deep trouble during the crash and burn of 2000-2002. There simply isn’t any evidence, though, that the Big 4 has ever learned from that episode. The most telling factor of the 2008-2009 crisis is that audit firms did little (or nothing) to curb corporate machinations and manipulations in the financial statements. The Big 4 can’t argue (with a straight face) that it deserves high audit fees for rendering quality audits. [I can’t deny that there are many good people populating the Big 4 and some of the time good work is accomplished. It’s possible here that we are simply talking about a change in the degree of auditor effectiveness.]

So, if is in the nature of the Big 4 to “get along,” and it is the nature of corporate managers to have their way, is it any surprise that audit prices are declining? I think not.

I think the current low level of auditor effectiveness will suffer as a result of this price competition. Here are some of the problems I see.

First, auditors will have less time on-site performing the audit. Although it is cheap grunt time, there will be less testing and evidence gathering. And decreased time will result in decreased audit effectiveness and less auditor power. Second, there will be renewed pressure to continue the problematic business model of audit firms relying on new hires. Fewer experienced professionals and partners will be around to supply judgment. Third, increased price competition will only increase pressure on audit firms to get along with management, or else there will be the loss of precious remaining revenues. Fourth, it will give more power to corporate management in the company-auditor relationship. If the U.S. moves to IFRS, audit firms will need to be in a position to exercise judgment and the power to express its will. At the current, they lack the will to unwaveringly express it. Too much price competition will turn the audit firms into cheaper whores.

If there is any hope for audit firms ever to serve the public interest, then this increasing price competition seriously damages the hope. Audit firms will be pressured to place their own self-interest over those of investors.

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2 Responses

Thanks for highlighting the “Auditing Your Auditor” story and for your kind words about my work. I’ve seen the story get similar attention elsewhere, including Lynn Turner’s listserve. Like you, he raises the concern that audit quality may suffer from price competition.

A couple of thoughts about that:

The first is to point out that the article makes that exact same point, noting that CFOs should not “simply seek the lowest possible cost.” We point out two extreme examples (Fannie Mae and Bernie Madoff) where curiously low audit fees were followed by outright disaster.

That said, the article notes that unusually high fees are also worrisome. Indeed, the AICPA suggests audit committees should benchmark fees, but doesn’t say why. Presumably the AICPA meant audit committees should check that fees are not too low — or too high.

You note in your post that “increased price competition will only increase pressure on audit firms to get along with management,” but unusually high fees can also suggest a lack of independence. After all, it was the SEC itself that pushed for fee disclosure and transparency in 2000 in an effort to disrupt the sometimes too-cozy relationship between companies and their auditors.

Benchmarking or reviewing fees — something any responsible CFO should do with any professional service — can keep those relationships on a professional level. But any responsible audit firm should walk away if asked to accept a price that compromises their audit work.

As the article notes, from 2000 to 2007, audit fees were never “normal,” but were elevated by audit firm mergers, confusion over how to perform control audits, etc. While it certainly makes sense to be concerned about price competition eroding audit quality, a strong case also can be made that the current trend is simply a reversion to the norm.

If I read correctly, I think you just called the Big Four audit firms cheap whores. Jeez, all your talk about accounting pornography seems to be rubbing off on your writing. However, I can’t say I’m sad to see it.

As I commented over at the CFO.com site, I think it’s about time we drove the cost of external audits (given today’s existing structure) down as low as possible–our corporations need as much profit improvement as possible to turn this economy around.

With the existing flawed foundation (auditors selected, managed and controlled by the companies they “audit”), the external audit creates little to no value in a well-run corporation. Internal audit in those comapnies does a much better job of managing the financial aspects of the business.

Thanks, David, for another interesting post. And I think you’re right–if we move to IFRS we might as well not even have external audits at all–the only point would be to rubber-stamp management’s “judgment.” According to CFO.com, that would mean at least $16 billion in U.S. corporate savings. Of course, I’m sure that would be more than offset by the IFRS Conversion Consulting fees that would result.